Bank Rally Looks Set to Stall

It's a tough time to play financial stocks, especially for investors who have been sitting on their hands the past few weeks.

That's because up until Monday's broad selloff, bank and brokerage stocks had been on fire. Now, there's reason to believe that many banks and brokerages won't be able to hold their gains in the coming months, especially if the economy can't shake its doldrums and the Federal Reserve moves to cut interest rates again, as many now expect it will.

The recent gains in financial stocks would seem to suggest that investors believe the economy is on the verge of a powerful recovery in the second half of the year. Since mid-March, when investors were still trying to handicap the outcome of the U.S. invasion of Iraq, financial stocks have risen 10% to 30%, on average. But skeptics say there's little evidence of any recovery yet, even though consumer confidence has perked up a bit with the end of active combat in Iraq.

Moreover, there's reason to doubt whether revenue growth at the nation's banks and brokers can match the most bullish expectations of investors.

David Trone, a financial-services analyst at Prudential Securities, contends that some investors in brokerage stocks seem to be banking on a revival in investment banking business. But Trone, in a recent research note, said there's no "tangible evidence" of any real thaw in the market for initial public offerings or corporate merger advisory work.

So Trone is advising Prudential customers to take a breather on the stocks of Wall Street firms. In particular, he lowered his rating on shares of Merrill Lynch ( MER) to hold from buy, noting it will be harder for the firm to generate stronger profits in the near term because it can't squeeze any further savings out of cost cuts.

It also appears the Federal Reserve may be about to throw a curve at investors in bank stocks.

The conventional wisdom is that a Fed rate cut is good news for the nation's banks because it spurs more consumer borrowing and reduces the bank's own borrowing costs. But the problem for the banks is that the Fed already has cut interest rates so many times, low rates are beginning to eat into the profit margins of their lending operations.

Last quarter, many banks reported sharp declines in net margin interest, or the difference between the interest rate banks charge on loans and their own borrowing costs. And in conference calls with analysts, many bank officials warned the declines could worsen, if the Fed were to cut rates again.

The trouble is that a Fed rate cut would force banks to once again lower the interest rates they charge on loans, which means a savings for borrowers. But many banks will find it difficult to reduce the interest rates they pay out to their depositors without driving their customers away.

In other words, a Fed rate cut would squeeze the banks and reduce the profitability of their lending operations. And the banks likely to be hardest hit by a Fed rate cut are regional lenders such as New Jersey's Commerce Bank ( CBH), Cincinnati's Fifth Third ( FITB) and New York's North Fork Bank ( NFB), which generate much of their quarterly earnings from net margin income.

"It's a very tough environment right now," said Michael Stead, a financial services portfolio manager for Wells Capital Management. "A rate cut would be bad for all the regionals."

A Fed cut also would be bad news for banks, both large and small, because some have been hedging their balance sheets in the expectation that rates will rise later this year. Stephen Biggar, a Standard & Poor's bank analyst, said banks that took these actions could get caught on the wrong side of an interest rate bet, if the Fed were to cut rates in the coming months.

In an uncertain economic environment, bank officials often have to make an educated guess about which direction interest rates are likely to move. And when banks are caught off guard by the Fed, it can cost them money.

Indeed, a bad bet on the future direction of interest rates cut into earnings at Bank One ( ONE) in the first quarter. The Chicago-based bank attributed roughly half of its 5% decline in its total revenue in the quarter to a premature calculation that the Fed would raise interest rates in the first quarter. The bank's bad bet involved a hedging strategy involving U.S. Treasuries.

All in all, it still looks like a dicey time for the nation's banks and brokers. And that's not the kind of environment that bodes well for the current rally.